Mutual Fund Managers Are Channeling Peter Lynch; You Should, Too

by Daniel Putnam | February 14, 2013 7:00 am

Why do mutual fund managers buy the companies they do?

Most fund investors would respond to this question with sensible answers such as “earnings outlook” or “valuations” or even “closet indexing,” but this would only cover part of the picture. In fact, many other factors come into play — including one that carries a lesson for individual investors.

This notable aspect of managers’ behavior has been elucidated in an academic study titled “The Home(-sickness) Bias of Foreign Holdings”[1] by Quoc H. Nguyen at the University of Illinois. Noting how the majority of investors tend to give a disproportionate weighting to their home markets, Nguyen sets out to determine whether managers also tend to use “home bias” when selecting international stocks for their funds.

The answer: Not only do they exhibit such a preference, but it’s actually a positive for performance.

Among the surprising results of his study, as well as other studies he quotes in his paper:

U.S. investment managers exhibit a strong preference for locally headquartered stocks, and mutual funds tend to overweight stocks from their managers’ home states.

U.S.-based mutual funds tend to hold larger weightings — 14% larger, to be exact — in stocks based in countries that have a large ethnic population near the fund company’s office. “For example,” Nguyen says, “mutual funds that are headquartered in regions with large Chinese population may hold more stocks from China, Hong Kong and Taiwan, because managers of those funds feel familiar with, or at least not apprehensive of, the foreign culture and companies.”

Not only that, but when the funds change locations, the fund managers tend to raise their weighting in stocks associated with the dominant ethnic group of the new location. Nguyen attributes part of this to the fact that the funds are more likely to hire locally, but not entirely — meaning that information flow from the local population definitely plays a part.

Fund managers tend to emphasize their home country — in fact, they tend to hold 9% more in their home country than the average fund. In other words, an Indian fund manager is likely to own more Indian stocks than a non-Indian manager.

The obvious question is, “Does this bias help or hurt performance?” Nguyen’s findings: Funds that overweight stocks from the local ethnic group’s home country do indeed outperform, and by a wide margin: 1.4 percentage points per quarter, on average.

This effect is almost entirely the result of outperformance within emerging markets funds; Nguyen found that home-bias had no impact in developed-market funds. This is consistent with the wider availability of information on developed-market stocks and the greater usefulness of “on the ground” research when it comes to those located in the emerging markets.

In short, you want to see your manager exhibiting this type of “home bias.”

What Does This All Mean?

These factoids not only provide insight into managers’ processes, but they contain a lesson for individual investors as well.

Most fund reports and marketing materials paint a picture of a scientific, systematic approach being employed by their managers. But as this study shows, fund managers in fact also use the traditional approach popularized by Peter Lynch in Beating the Street — “You have to know what you own, and why you own it.” If an informational advantage comes from a manager’s interaction with the local population or special insights about his or her home country, he or she will put this advantage to use. Based on Nguyen’s numbers, it’s an approach that’s working.

And for individuals, the outperformance of fund managers who capitalize on local information flow is clear: Some of the best investment ideas might be right under your nose.

For investors who want to conduct further investigation on this topic, the full study is available here[2].

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.